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By timestaff
January 26, 2013

It’s widely accepted that at some point interest rates will rise and the value of bonds in the U.S. will fall. Given that, do you think bond investors might find some fixed-income shelter in emerging market bond funds over the next five to 10 years? — Steve W., College Station, Texas

I agree that most people expect that U.S. interest rates will rise in the near future. In fact, the yield on 10-year Treasury bonds has already climbed nearly a half a percentage point, moving from its July 2012 low of just over 1.4% to a bit below 1.9% recently.

But if you’re looking for protection from possible setbacks in bonds, I don’t see moving into emerging market bond funds as much of a solution. If anything, I see it as a potentially dangerous move.

By virtually any measure, emerging market bond funds are riskier than their U.S. counterparts.

They typically have longer durations — a fancy way of saying their prices will fall more if interest rates rise (although that drop can be offset to some extent by their generally higher yields).

Their portfolios have a lower average credit quality, typically below investment-grade. And because still-developing economies are more vulnerable to economic, financial and currency woes of every sort, emerging market bonds are just much more volatile overall.

Emerging market bond funds’ standard deviation, a statistic that measures how much an investment’s returns bounce up and down, can be triple that of the broad U.S. taxable bond market.

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But you don’t even have to sift through these kinds of indicators (which you can find in the Portfolio tab on any bond fund’s Morningstar page) to see that emerging market bonds aren’t a safe haven. Just look at how they fared when the financial system went haywire back in 2008. Between August and October of that year, emerging market bonds lost just over 25% of their value.

You would have also lost money during that period had you owned a total bond market index fund that holds a combination of U.S. government and corporate investment-grade bonds, but the hit would have been much more mild, roughly 3%.

I don’t mean to suggest that no one should ever own emerging market bond funds. They have been one of the top-performing categories of bond funds over the past three and five years, churning out annualized returns of 11.2% and 9.4%, respectively. But the reason they generate such high returns is that these bond funds also come with outsize risk.

So while someone willing to accept that risk to juice returns might consider putting a small portion of his bond holdings in emerging market bond funds, they aren’t the go-to choice if your cry is “gimme shelter.”

What should you do, then, if you’re worried that rising rates will trigger losses in bonds?

You have a few choices. One is to get out of bonds entirely. But that leaves you with the question of where to put the money you had in bonds. You could move it to cash, and you would get the safety you seek. But you’d earn virtually nothing, and possibly less than what you’d get in bonds if interest rates remain stable or rise only slightly.

You could switch to stocks. But downturns in the stock market are likely to dwarf any setback you would experience in bonds. So you would be taking on much more risk by going to equities, even if you shifted into dividend-paying stocks. And whether you jumped to cash or stocks, you would still face the issue of when to get back into bonds. Timing markets is always an iffy affair. There’s always the chance you could return to bonds only to see rates head upwards.

My recommendation: Stop trying to predict what interest rates will do and just decide what percentage of your portfolio should be in bonds based on your goals and risk tolerance. Then, aside from periodic rebalancing (or possibly increasing your bond exposure as you age), let it be.

If you want to limit the downside of rising rates, you can invest in bond funds that stick to the short- to intermediate-maturity range of the market. You’ll find bond funds that do just that — including my choice, bond index funds — in our Money 50 list of recommended funds.

The bond portion of your portfolio may still very well take a hit if rates climb. But chances are it won’t be a very big one (certainly not by stock-market standards) and, as this report explains, any decline should eventually be offset as the fund invests in bonds with higher yields.

So if you want to take a shot at loftier gains and you’re willing to accept the higher risk that involves, by all means consider devoting a small portion of your bond stake to emerging market bond funds. But if it’s shelter you seek, forget them.

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